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One of the most disappointing aspects of the financial crisis, recession, and bear market of 2008 where stocks posted a peak-to-trough decline of just over 50%, was the fact that nearly all investments declined similarly. Diversification failed when it was most needed.
Correlation, the measure of how coordinated the movements among investments are, usually rises during downturns. Performance is often driven more by unique, asset-specific factors during upwardly sloping markets, but during a downturn investments are more likely to be driven by a sudden change in “big picture” factors common to all of them. The 2008 markets took this rise in correlation to a new extreme.
Not all assets saw their correlation rise during past recessions, such as those in 1991 and 2001; some asset classes remained effective diversifiers of risk. For example, during the 2000-2002 bear market—which resulted in a 49% decline in the S&P 500 index and included a recession—asset classes such as REITs, Commodities, Small Cap Value stocks, and even various sectors of the Large Cap stock market provided diversification benefits, as the correlations of these asset classes with the S&P 500 remained relatively low.
In the current bear market, almost no asset class was spared sharp losses. From peak-to-trough, the stock market (measured by the S&P 500) fell 52%, commodities (measured by the CRB/Reuters Commodity Index) fell 52%, international stocks (measured by the MSCI EAFE index) fell 56%, emerging market stocks (measured by the MSCI Emerging Market Index) fell 64%,
preferred stocks (measured by the S&P Preferred Stock Index) fell 57%, REITs (measured by the NAREIT composite index) fell 70%, High Yield bonds (measured by the Barclay’s High Yield Index) fell 35%. In addition, while the Financials sector was the source of the bear market’s problems, all sectors fell significantly, and the correlations rose as they traded as one monolithic asset class. Only Treasury debt, the lone safe haven, was spared losses and maintained a negative correlation with the stock market.
The market performance of 2008 begs the question: Is diversification dead? Fortunately, the answer is no; we just have to look in non-traditional places to find it.
Correlations are rising among traditional asset classes as the globally common factor of credit increasingly affects all facets of the traditional markets. However, just as the old tools of portfolio management are rendered less effective, new tools are ready to be put to use. It is time to look beyond traditional investments. Some types of alternative investments can help deliver the effective diversification and the low correlations previously found among traditional investments. These strategies passed a critical test in 2008. Alternative mutual fund strategies, such as the Global Macro and Managed Futures styles of investing, provided a low or even negative correlation with the stock market in 2008, and were useful for helping manage risk and return in portfolios. (Managed Futures are also known as Commodity Trading Advisor (CTA) investments.) Keep in mind, Alternative Investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of Alternative Investments may accelerate the velocity of potential losses.
We continue to recommend that a significant portion of a portfolio, across all risk objectives, be allocated to alternative strategies. The benefits of diversification and low correlations among assets are the only “free lunches” when it comes to investing.
The success of efforts to seek significantly superior risk and return by combining diverse assets depends on correlations remaining low when they are needed most.One of the most important lessons of 2008 is that traditional assets alone may not provide adequate diversification.
IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.
Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.
The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a Registered Investment Advisor. Tax and mortgage services provided are not affiliated with LPL Financial.
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—which resulted in a 49% decline in the S&P 500 index and included a recession—asset classes such as REITs, Commodities, Small Cap Value stocks, and even various sectors of the Large Cap stock market provided diversification benefits, as the correlations of these asset classes with the S&P 500 remained relatively low.
class. Only Treasury debt, the lone safe haven, was spared losses and maintained a negative correlation with the stock market.
Alternative mutual fund strategies, such as the Global Macro and Managed Futures styles of investing, provided a low or even negative correlation with the stock market in 2008, and were useful for helping manage risk and return in portfolios. (Managed Futures are also known as Commodity Trading Advisor (CTA) investments.) Keep in mind, Alternative Investments may not be suitable for all investors and should be considered as an investment for the risk capital portion of the investor’s portfolio. The strategies employed in the management of Alternative Investments may accelerate the velocity of potential losses.
We continue to recommend that a significant portion of a portfolio, across all risk objectives, be allocated to alternative strategies. The benefits of diversification and low correlations among assets are the only “free lunches” when it comes to investing. 